Rising rates in EM: Investors should distinguish between credible and reactive monetary policy

Posted on August 2, 2018

After falling to a historically low level in Q1 2018, inflation accelerated across most emerging markets over the last few months. The inflationary rise was particularly sharp in Turkey, Central & Eastern Europe and a selection of Latin American countries. Only Asia has not seen the pick up in price indices.

The underlying drivers of this rise in inflation have been mainly external: rising oil prices have fed into domestic fuel prices, while trade tensions led to a depreciation of most EM currencies, reflecting in higher import prices. Organic domestic pressure remained muted through the period, as the output gap stood flat to negative in most EM regions. The notable exception was Central & Eastern Europe, which scored as the fastest growing region. In Latin America, food prices are slowly normalizing after exceptionally low food inflation in 2017.

Barring any significant external shock, we do not see EM inflation accelerating at the same pace going forward. Instead we expect inflation to plateau in the next quarter or so and then to gradually resume its downward trend next year. Most analysts share this benign outlook and see the current increase in inflation as transitory. Inflation expectations have not been disrupted by the increase in realized inflation, and economists have broadly looked through the recent move (Chart 2). One notable exception has been Turkey, where a brutal acceleration in inflation (from 8-9% on average for the 2013-2016 time period to 15.4% in July) has forced expectations to drift higher.

Many EM central banks have chosen to err on the cautious side by adopting relatively hawkish stances, beyond what their domestic economic situation would require. Beyond the PBOC (China), virtually all EM central banks opted to a tightening or unchanged bias. We have seen the EM Aggregate Central Bank policy rate rising in H1 2018 (Chart 2), driven by hikes from Mexico, Argentina, Indonesia, India, Malaysia, Turkey, Czech Republic and Romania. Central banks in Russia, South Africa, Brazil and Peru have opted to abstain or slow down their easing cycle despite very subdued inflation profiles.

Despite an overall hawkish turn, it is key for investors to distinguish between credible and reactive central banks. Banxico (Mexico) stands out on the credible side as it moved in advance of political uncertainty and thus hiked rates pre-emptively well beyond what the macroeconomic situation required. BI (Indonesia) also belongs in the credible camp as we saw it attempt to strengthen the currency by lifting rates twice since May despite very well behaved inflation. CNB (Czech Republic) was one of the first central banks in the European Union that started to tighten monetary conditions last year, at a time when the ECB was still deeply engaged in its Quantitative Easing program. The CNB already hiked twice in the first half of 2018, despite a soft patch in European growth, and is expected to hike again this week.

Some central banks have been more reactive in the period. Both the CBRT (Turkey), and CBRA (Argentina) have been tested by the market, and both have seen their respective currencies experience significant pressure. CBRT and CBRA hiked policy rates by 975bps and 2300bps respectively, as an illustration of how costly it can be for an EM central bank to be late into the game.

While more hawkish policy has a growth cost, more credible EM central banks are promoting stability both in terms of domestic inflation and in terms of their currency. Firms will be able to plan ahead and foreign investors (FDI and portfolio flows) will more confidently re-engage into these countries. Over the medium term, local currency investors should overweight the countries where the real policy rate is high as it acts as a currency stabilizer in the short term, an attractive carry in the medium term, and offers potential for rate cuts in the long term. Based on these metrics, Mexico, South Africa and Indonesia may offer opportunities (Chart 3).

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